Business Maverick


Lessons from the UK fiscal policy mess and financial market meltdown

Lessons from the UK fiscal policy mess and financial market meltdown
Prime Minister Liz Truss is seen leaving Downing Street on 27 September 2022 in London, England. (Photo: Rob Pinney / Getty Images)

The UK’s economic misfortunes tipped over into a full financial market meltdown on the news that UK Prime Minister Liz Truss was cutting taxes more than expected with no communication about how the government would fund this. The financial markets’ response was swift and brutal, providing a case study for other leaders on what not to do.

The UK dominated global headlines this week when the government announced a mini-budget that included $48.6-billion in tax cuts, which it can ill-afford. Investors voted with their feet, causing a financial market meltdown of historic proportions as demand for 30-year government bonds dried up completely, the pound raced towards parity against the dollar, and bond and equity investors around the world were caught in the fallout.   

The financial markets’ response was more akin to what happens in an emerging market and highlights what countries can expect when politicians ignore economic realities — everyone loses. The UK government has lost its credibility, investors have been subject to crisis levels of uncertainty in already volatile markets, homeowners now face the prospect of paying another percentage point or more on their mortgages, and pensioners are, arguably, the worst hit because of soaring bond yields. 

Worst of all, the “unconventional and unpopular” measures, which Prime Minister Liz Truss steadfastly supports notwithstanding their already dire consequences, aren’t even likely to achieve her political commitment to boost economic growth. Economists are downgrading their UK growth projections and raising their interest rate projections by a percentage point at least. 

Truss’s decisions are likely to go down in history as a case study of what not to do. Even the International Monetary Fund took the unusual step of pressing the prime minister of a G7 country, not an emerging market, to rethink the decision to cut taxes 

However, there are some important lessons that we can take out of this week’s UK market meltdown. 

The intensity of the market’s reaction gives unnerving insight into how quickly the global high-inflation crisis can turn into a financial crisis. Chris Turner, ING’s global head of markets, notes: “Events in the UK marked the first time this stagflationary macro environment risked evolving into a financial crisis. Fortunately, the Bank of England intervened aggressively in the gilt market, and market conditions have temporarily stabilised. However, there will be no room for complacency this autumn as volatility returns to 2020 highs.” 

Financial liquidity is not just an issue in UK markets, it has been looming in the US markets too since earlier this year. With all the geopolitical and macroeconomic risks that still prevail, the UK market meltdown suggests that financial markets may be a lot closer to the precipice than we think. 

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The overwhelming vote of no confidence in Truss’s tax measures also highlights how easy it is for a government to lose credibility and how hard it is likely to be to win it back. Market participants were quick to label the UK an emerging market — some even calling it a submerging market — because they believe the numbers just don’t add up.

Introducing an unfunded fiscal package like this threatens to make the country look like an emerging rather than developed market because the country already has emerging-marketlike twin deficits: a 6% of GDP current account deficit and a 6% of GDP fiscal deficit. Added to this, real interest rates are at -10%, and the pound has fallen by 20.3% this year. 

Remi Olu-Pitan, Schroders’ head of multi-asset growth and income strategies, says for the UK government to regain its lost credibility, something will need to happen to give international investors confidence to dip their toe into UK assets again. 

“At the moment, investors need more confidence, and that needs to come from both the Bank of England and the government to allay a lot of those fears. Until then, investors will demand a higher risk premium for owning UK assets, and that has to come either via sterling weakening further or government bond yields rising further. So, things might need to get even cheaper first.” 

Right now, the Bank of England is working hard to win back some of that credibility by stepping into financial markets to settle volatility in the UK government bond market. It announced this week that it would push out its quantitative tightening programme and instituted a long-term bond-buying programme to “restore orderly market functioning”. 

Meanwhile, financial markets are scheduled to find out only in late November how the UK government intends to finance its tax cuts, and the cost of its plan to alleviate energy costs. For now, it appears that there’s little chance that Truss and Chancellor of the Exchequer Kwasi Kwarteng will roll back the tax cuts. But they may well impose stringent expenditure cuts — an alternative that is not likely to be well received at all. 

Events over the past week also highlight the policy imbalance that has been in place since the 2008 financial crisis, with central banks taking on the lion’s share of the responsibility of keeping the economy on an even keel. Fiscal policy decisions are often at odds with monetary policy objectives, and, like now, it’s central banks that are called upon to pick up the pieces. 

Paul Donovan, UBS GWM’s chief economist, says the Bank of England was confronted with a financial system that was increasingly paralysed because of the UK government’s fiscal policy, and it had to take action because “the principal objective of any central bank must be to ensure the financial system functions”. 

It’s tempting to respond to what’s happened in the UK with a sense of relief that it isn’t happening in our own country. But that would be premature, because it’s a keen reminder of how quickly financial market conditions can take a turn for the worse wherever you are in the world. DM/BM


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